A fundamental analysis strategy is the investment in stocks on the basis of the value of the companies represented by the stocks. The company's balance sheet, income statement, etc., are studied to help determine the financial and market position of the company. If the analysis of the company's historic growth and profit patterns shows a steadily growing organization, and the research of the organization and its markets show a company that is competent and sound, a fundamental analysis approach may conclude that the company should continue to grow and prosper.
On the other hand, a technical analysis strategy involves trying to make profits based on the short-term swings of the market, such as, for example, day traders, who try to take advantage of hourly or daily price changes to make a profit. Slightly longer-term technical analysis investors track stock price and trading volume fluctuations over a period of a few days or weeks and trade on the basis of recent trends. As opposed to fundamental analysis where the emphasis is on the strength of the underlying corporation, technical analysis focuses on patterns that appear on the historical price charts of a specific stock and of the stock market in general in order to help predict the future of that stock's price. This strategy is based on the theory that certain patterns of stock prices tend to repeat themselves over time.
The Internet provides a great variety of uses including the buying and selling of financial instruments. The Internet has become a major means by which investors and brokers can both monitor the stock market and buy and sell stocks.
Although an investor does not need to be online to buy stocks, Internet access may be of great value. The Internet offers resources that are unmatched by any single print source. A wired investor can get access to literally thousands of investment services, publications, newsletters, and discussion groups. In this manner an investor can quickly gather a large amount of information about various financial instruments, including information about companies whose stock may be of interest.
The stock market includes a number of features that affect the stock investor. One of these features is the existence of agents to facilitate the functioning of the market. Market makers, specialists and Electronic Communications Networks (ECNs) make market in stocks. Market makers are part of the National Association of Securities Dealers market (NASD), and specialists work on the New York Stock Exchange (NYSE) and other listed exchanges. An ECN is an electronic board where buy and sell orders may be posted by any investor worldwide. These agents serve a similar function but there are a number of differences between them.
The New York Stock Exchange (NYSE) is the oldest stock exchange in the United States. The NYSE (as well as the Philadelphia, Chicago, Boston, and Pacific Stock Exchanges) uses an agency auction market system that is designed to allow the public to meet the public as much as possible. The majority of trading volume (approximately 90%) occurs with no intervention from the specialist. The responsibility of specialists is to make a fair and orderly market in the issues assigned to them. They must yield to public orders, which means that they may not trade for their own account when there are public bids and asks better than their own. The specialist has an affirmative obligation to eliminate imbalances of supply and demand when they occur. Specialists are required to make a continuous market. The exchange has strict guidelines for trading depth and continuity that must be observed. Specialists are subject to fines and censures if they fail to perform this function. NYSE specialists have large capital requirements and are overseen by Market Surveillance at the NYSE.
A specialist will typically maintain a narrow spread between offers to buy and offers to sell. Generally, the trader will need access to a professional's data feed before the trader can really see the size of the spread.
There are over a thousand NYSE members (i.e., seats), of which approximately a third are specialists. There are over 3000 common and preferred stocks listed on the NYSE. On the average, each specialist handles 6 issues. The very big stocks may have a specialist devoted solely to them.
Every listed stock has one firm assigned to it on the floor. Most stocks are also listed on regional exchanges in San Francisco, Chicago, Philadelphia and Boston. All NYSE trading (approximately 80% of total volume) occurs at that post on the floor of the specialist assigned to it.
The National Association of Securities Dealers Automated Quotation system (NASDAQ) is an interdealer market represented by over 600 securities dealers trading more than 15,000 different issues. These dealers are called market makers. Unlike the NYSE, the NASDAQ market does not operate as an auction market. Instead, market makers are expected to compete against each other by posting the best quotes (best bid, i.e., best offer to buy, and best ask, i.e., best offer to sell).
A NASDAQ Level II quotation system shows all the bid offers, ask offers, size of each offer (the order size), and the market makers making the offers. The order size is simply the number of shares the market maker is prepared to fill at that price. Since about 1985 the average person has had access to Level II quotes.
The Small Order Execution System (SOES) was implemented by NASDAQ following the 1987 market crash. This system is intended to help the small investor have his or her transactions executed without allowing market makers to take advantage of the small investor. The trader may see mention of “SOES Bandits” which is slang for people who day-trade stocks on the NASDAQ using the SOES, scalping profits on the spreads.
A firm can become a market maker on NASDAQ by applying to NASD. The requirements include certain capital requirements, electronic interfaces, and a willingness to make a two-sided market. The trader must be there every day. If the trader doesn't post continuous bids and asks every day the trader can be penalized and not allowed to make a market for a month. Market makers are regulated by the NASD, which is overseen by the SEC.
The brokerage firm can handle customer orders either as a broker or as a dealer/principal. When the firm acts as a broker, it simply arranges the trade between buyer and seller, and charges a commission for its services. When the firm acts as a dealer/principal, it's either buying for or selling from its own account (to or from the customer), or acting as a market maker. The customer is charged either a mark-up or a mark-down, depending on whether they are buying or selling. The firm is disallowed from charging both a mark-up (or mark-down) and a commission. Whether acting as a broker or as a dealer/principal, the brokerage is required to disclose its role in the transaction. However, dealers/principals are not necessarily required to disclose the amount of the mark-up or mark-down, although most do this automatically on the confirmation as a matter of policy. Despite its role in the transaction, the firm must be able to display that it made every effort to obtain the best posted price. Whenever there is a question about the execution price of a trade, it is usually best to ask the firm to produce a Time and Sales report, which allows the customer to compare all execution prices with the actual execution price reported to the customer.
In NASDAQ, the public almost always trades with the dealer as a counterparty instead of another public investor, making it nearly impossible to buy on the bid or sell on the ask. Dealers can buy on the bid even though the public is bidding at the same price. Despite the requirement of making a market, in the case of market makers as opposed to specialists, there is no one firm who has to take responsibility if trading is not fair or orderly, as what seemed to have happened during the crash of 1987. At that time, many NASD firms simply stopped making markets or answering phones until prices were less volatile.
Recently, Electronic Communication Networks (ECN) were established in order to allow investors to trade NASDAQ listed stocks without having to go through market makers, oftentimes resulting in better prices for the investor. An ECN is an electronic system where buy and sell orders may be posted by any investor worldwide, where any investor or dealer may trade against that order. The best bid and best ask orders from the ECN are posted in the NASDAQ system alongside those of market makers.
If a trader wants to buy or sell a financial instrument, such as a stock or other security, in an open market, the trader normally trades via firms who act as agents who specialize in that particular security. These firms stand ready to sell the trader a security at the asking price (the “ask”). Or, if the trader owns the security and would like to sell it, the agent buys the security from the trader at the bid price (the “bid”). The bid and the ask prices remain until a new price is set. The difference between the current bid and the current ask is called the spread. Financial instruments that are heavily traded tend to have very narrow spreads (e.g., a few cents), but financial instruments that are lightly traded may have spreads that are significant, even as high as several dollars.
The width of the spread is indicative of the financial instrument's liquidity. Liquidity basically measures the aggregate quantity investors are willing to buy or sell of the financial instrument at any time. In the stock market, market makers or specialists (depending on the exchange) buy stocks from the public at the bid and sell stocks to the public at the ask (called “making a market in the stock”). At most times (unless the market is crashing, etc.) these people stand ready to make a market in most stocks and often in substantial quantities, thereby maintaining market liquidity. Dealers earn profit by realizing a large part of the spread on each transaction—they normally are not long-term investors.
Two types of online trading available to the public are: Internet trading provided by firms that route a customer's order to a trading desk or to a third party willing to pay for order flow; and dedicated online services provided by firms where customer's orders go directly to the exchange or ECN offering direct execution.
If the online investor uses the first type of online trading discussed above, the customer's order may be gamed by a specialist or market maker handling the order. Unfortunately, if this happens to the customer, they may not be able to recognize that it has happened from the minimal information typically provided in the order confirmation. Typically, this type of customer only has access to what's called Level I data—the best bid, the best ask, the last trade, and the order size of each data respectively.
If the customer uses the second type of online trading discussed above (i.e., the order goes from the firm directly to the exchange), the customer most likely is looking at a NASDAQ Level II screen. This screen shows all the bid offers, ask offers, the recent trades, the size of each offer or trade, and the market makers and ECNs making the offers.
An online trader connected to a web site that has a screen that displays NASDAQ Level II data, may see the following information streaming continuously on the screen: all bid offers, all ask offers, all trades, the size of each offer or trade and the market maker or ECN making the offer. This data may be refreshed as often as ten times per second. Hence, many traders are continuously analyzing the data on their screen all day. Moreover, unless the trader has a prodigious memory and even then the information may arrive too quickly to be fully read, much less utilized by the trader. The more individual financial instruments monitored by the trader, the greater the difficulty in utilizing the flood incoming data. Thus, a lot of important information may escape notice. Additionally, impatience at waiting for the desired trading condition may cause the trader to make a trade at an inopportune moment. Thus, an automated means of analyzing this wealth of information is desirable.
The present invention involves methods of modeling financial markets and automating trades to take advantage of this plethora of bid and ask price data.